The life and death of bonds, or Bill Gross's scalp
I've been trying to understand how bonds work, specifically municipal bonds, so I can better understand school finance. But the subject is notoriously difficult to grasp. Unfortunately, there are very few engaging ways to learn about bonds. This lack of comprehensible material that explains municipal bonds is actually a big pedagogical problem since school district officials have to spend so much time issuing and then managing their bonds, yet they get little to no training about this until they get into their positions. Plus, there's no way for anyone--practitioners or researchers--to think beyond the status quo. How can we transform a system that only insiders understand?
To figure this out, a couple months ago I searched for non-fiction books about municipal bonds. I was looking for books as readable, narrative, and character-based as possible. I found two and read them one after another. It was super helpful and really interesting. The books are very different but together they provide a view of the bond world that I couldn't have gotten otherwise.
The Bond King by Mary Childs is a very recent book about Bill Gross, the chief investment officer of PIMCO and known, indeed, as the Bond King for his historic transformation of the bond market into a site for go-go profit-making. TBK is focused on corporate bonds, which are loans that private companies take out to finance their operations, but since they're still bonds you get a lot of fine-grained dynamics about bond markets. It's a dirty ruling class story, like Succession or The Big Short, a genre of infotainment that gives a look into the lives of the most filthy rich people and how terrible they and their lives are.
The other book I read is older and focuses on an entirely different period of bond history, as well as municipal bonds themselves: you have to read Confessions of a Municipal Bond Salesman by Jim Lebenthal to believe it. Somewhere between a memoir, business self-help book, and Poor Richard's Almanac, this first-person romp are the reflections of Lebenthal's life selling municipal bonds in New York City. This post is about Gross and the next one will be about Lebenthal.
The life and death of bonds
Like other aspects of finance in the late 20th century, the bond market went from a sleepy place for slow fixed-rate profit to a roiling go-go market. The man credited with whipping credit markets into that frenzy is Bill Gross. "Gross helped to swell the finance industry, and it was disproportionately massive relative to the economy to which it was attached, with correspondingly disproportionate salaries and bonuses, protected by defensive layers of jargon and derivative complexity so no one would try to get wise." When it comes to understanding how finance capital got so out of control in the lead up to 2008 and remains a parasitic hurricane in our economic life, the story is instructive. But it's also instructive about bonds.
Childs's book about Gross's rise and fall is punchy and informative, telling a good story but also doing a pedagogical service in that you get a sense of the bond market over the transition just described. We get details about Gross and the gross trading he invented. For instance, we get a great portrait of the bond market when Childs tells how it is that a life insurance agent--Pacific Mutual--got into bond trading. It turns out the rhythm of bond trading and death are similar enough to be profitable:
The business of life insurance necessitates knowing generally how many customers will die each year, how much an insurer will need to pay out, and when-ish. Usually it's not for awhile. So Pacific Mutual could take its customers' life insurance premia and invest the money in bonds that throw off interest payments until they mature (and return the money) approximately when the insurer expects to need it back. It could pretty safely buy a thirty year bond, and earn the interest, with money from customers who most likely wouldn't die for another thirty years.
People pay into their life insurance policies over the course of their lives. While they pay those premiums the insurance companies turn a profit by putting that money into bonds, which mature over long periods, just like human lives. It's a great illustration of the temporality of bonds, which pay out interest over the course of a whole life. Gross came upon this system as a young trader and amped it up.
From coupons to the client craze
We get another great image of the bond market when Childs talks about what Gross would do in his early days. He would put bonds together, research which ones to invest in, and then literally go down into basements, tear off coupons from bonds when they matured, and mail them into the borrower to get the interest and principal payments. I've always wondered what "coupon" means in the bond context and this is very helpful: the word comes from when bond investors--lenders--would literally cut a piece of paper worth a certain percentage of the total bond amount and redeem it by mailing it to the lender, who would have to pay them.
What Gross realized is that he could make these investments more frequently, more riskily, and more differentially, thereby getting a ton more interest payments. Rather than a sleepy forest of slow-growth trees bearing fruit and seeds at their own pace, Gross grafted new plants to the old trees and used new chemicals to generate exponentially more yields. His approach followed a more general trend post 1975 in finance, which was to do anything to increase the client's profit, even at the expense of entire governments: "If pushing governments and companies is okay if it is done in service of the client, arguably people with money invested at private money managers outranked taxpayers. The public pays to serve capital holders. But this wasn't Pimco's problem. Its interests stopped with the client. The rest was society's concern."
Scalps and crashes
Bonds are the way that local, state, and federal government entities get financing. Gross, following this client-based ethos, whipped the market up into a frenzy that contributed to the huge crash in 2008. So Childs gives us a great portrait of the bond market in this crash course transition. And speaking of crashes, I couldn't pass up this detail about Gross literally losing his scalp as a college student going on an errand for his fraternity:
On a Saturday night in 1966, Gross's Phi Kappa Psi brothers sent him out to get donuts for potential recruits--"nobody trusted me to do anything but buy donuts"--but, speeding, he lost control of his Nash Rambler and smashed into oncoming traffic. He went through the windshield, which sliced off three quarters of his scalp, detaching it entirely.
There's something gruesomely poetic about the fact that this fraternity couldn't trust Gross to do anything other than get donuts. He was clearly reckless in a number of ways, including speeding on his motorcycle without a helmet. And during the one mundane task he tried to accomplish for them, he lost his scalp in a crash. It's a pretty good metaphor for what he did for the bond market, which is a place that many school districts have to go for their facilities financing.
Whenever we think of how our school buildings are crumbling, we have to think of this bond market as the place where districts and states are supposed to go for the resources to maintain them. Do we really want to trust our school buildings to the market that Gross built?